The new Big Short: China may soon rock the global financial system

You will not find a movie this year that is both more powerful and more relevant than The Big Short, especially as history is repeating itself.

Based on a non-fiction book by the superb Michael Lewis, the film has been nominated for best picture at the Academy Awards, has a powerhouse cast – Brad Pitt, Christian Bale, Ryan Gosling, Steve Carell – and a powerhouse message: the collective greed, ignorance and duplicity of America's banks caused the 2007 financial crisis.

China's excess allocation of capital is coming home to roost, according to American fund manager Kyle Bass. Photo: Qilai Shen/Bloomberg

Americans remain resentful that the banks had to be bailed out by the federal government, at a cost more than a trillion dollars, that not one senior banker went to jail, and the gap between the super-wealthy and the middle class has never been greater.

This resentment is finding political expression in the meteoric rise of Senator Bernie Sanders, a socialist from Vermont.

In the past week, he fought Hillary Clinton to a draw in the first vote in the Democratic presidential nomination, in Iowa and now has trounced Clinton in the New Hampshire primary by 21 per cent.

One of the keys to his rising popularity is this message, made after both contests: "We are going to impose a tax on Wall Street speculation. The greed, the recklessness and the illegal behaviour of Wall Street drove this economy to its knees. The American people bailed out Wall Street, now it's Wall Street's time to help the middle class."

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Anyone who has seen The Big Short, and been moved by it, would have sympathy for his message.

The basis of the film's title was a billion-dollar bet placed in 2007 by a financial analyst, Dr Michael Burry. Unlike thousands of bankers, regulators, credit rating agencies and financial analysts, he examined the detail of the products that were being packaged for sale as mortgage-backed securities.

Burry became certain that many of these loans would default as soon as variable interest rates increased. He found a banking casino built on unsound debt and lax government supervision.

He bet his entire investment fund on shorting the mortgage-backed securities industry. To go short is to bet that a stock or security or currency will go down. To go long is to bet it will stay up.

Ominously, another credible big short is unfolding now.

An American fund manager, Kyle Bass, has bet most of the assets of the Hayman Capital Hedge fund, based in Dallas, that the Chinese currency, the yuan, will be significantly devalued.

Bass believes most people are mistakenly assuming that China's massive US$3.3 trillion ($4.7 trillion) in foreign exchange reserves is enough to insulate its currency from turmoil. It is not.

"So many people see China's US$3.3 trillion in reserves and think they can burn their foreign exchange to zero, so they have years ahead of them, but they really only have a few months," he told CNBC on Monday.

The rate of loans at serious risk of default on Chinese bank's books is at least 3 per cent of assets. "That's a trillion dollars," says Bass.

There is also capital flight. "There are 1.3 billion people in China. If 4 per cent of the population took out their US$50,000 limit, the $3.3 trillion in foreign reserves is gone...

"The International Monetary Fund stipulates that China needs about US$2.7 trillion in foreign exchange just to operate their import-export business. They'll hit that number in the next five months."

Bass has credibility because he was one of the few, like Michael Burry, who foresaw the sub-prime crisis, bet big and won big.

"The Chinese financial system is over-stretched. China let the banking system grow 1000 per cent in 10 years. Ten years ago it was less than US$3 trillion in assets. Today it is US$34.5 trillion. That's three and a half times their GDP. And they haven't had a loss cycle… That's crazy. China's [ratio of] bank assets to resources, is now one of the worst in the world.

"By comparison, the US sub-prime problem was US$400 billion on balance sheets, we lost US$882 billion… and had US$16 trillion in our banks."

"They are going to have to recapitalise their banks... by trillions and trillions of dollars… So a Chinese devaluation of 10 per cent is a pipe-dream. The yuan will go down by 30 to 40 per cent."

He has bet a billion dollars that this will happen, and will roil the global financial system.

"This isn't an aberration. This is China's excess allocation of capital coming home to roost."